The UK has lost its position as a genuine haven
THE notion of the UK as a safe haven is unravelling. As more economic data filters through, and questions about the UK’s role within Europe continue to dominate headlines, the pound is set to come under intense pressure.
On a trade-weighted basis, sterling has fallen in value by 20 per cent since the start of the financial crisis. And since the beginning of the year, it has been among the worst-performing G10 currencies, lurking at 10-month lows against the euro and the dollar (currently around €1.19 and $1.58 respectively).
SAFE NO MORE
The phrase “safe haven” refers to countries with good growth prospects; low, stable inflation; and budget and trade surpluses.
But with forecasts for UK annual growth in 2013 at an anaemic 1.5 per cent at best; inflation stubborn at 2.7 per cent; and yesterday’s confirmation that the government’s fiscal consolidation plans are off-course (the budget deficit is now around 8 per cent of GDP), the UK hardly fits the bill.
If anything, over the last few years the UK has just been a safer place for investors to park their cash than other countries. Mike Ingram of BGC Brokers suggests that it was the UK’s political stability, when the rest of Europe was in turmoil, that gave the perception of safety, along with a low risk that the UK would default on its government debt.
TWISTED IRONY
It is ironic that as the Eurozone’s political environment stabilises, the UK’s looks more risky. Prime Minister David Cameron delivers his long-awaited speech on Europe this morning, and there is a high chance that the UK’s EU membership will be put to referendum in the near future.
This will rattle sterling traders. “Markets like stability,” Ingram says, and “the prospect of the UK leaving Europe [however unlikely] presents policy uncertainty”. Any uncertainty may drag on the pound.
DOVES WILL FLY
Sterling will come under further pressure at 9.30am today, when the Bank of England releases minutes from its latest policy meeting. Mansoor Mohi-uddin of UBS thinks “the minutes are likely to be dovish,” and “will leave the door open to more easing”.
The prospect of more easing will cheer markets, since it helps boost equities and lower bond yields. But it will weigh on sterling. It is also questionable whether another dose would benefit the economy, given the limited success of the last round.
Some also argue that excessive easing gives rise to zombie corporations, which would not survive if interest rates moved higher. There is merit to this argument: while employment in the UK has improved, productivity has fallen, and this will hinder long-term economic growth prospects.
TRIGGER-HAPPY
Worryingly, the UK has been more trigger-happy with easing than any other major nation: as a percentage of GDP, the Bank of England has eased to the tune of 24 per cent. Compare that with the Federal Reserve (17 per cent), the European Central Bank (less than 3 per cent), and even the ultra-loose Bank of Japan, which has eased to the tune of 8.5 per cent (so far, but this will rise).
The Bank of England is now also the largest investor in gilts. This is one of the central reasons why government bonds have performed well since the start of the crisis – not the market’s faith in the UK’s fundamentals.
This could be unsustainable in the long term and, as markets move into “risk-on” mode, at some point yields must climb higher (they are already up to 2 per cent, from 1.5 per cent in the middle of 2012). Ingram says that as the risk-on move continues, there will be less need for apparent safe havens, and gilts will be vulnerable.
GOODBYE TRIPLE-A
Friday will complete judgement week for sterling, with the release of the latest GDP data. Recent purchasing managers’ surveys do not augur well. The services sector contracted in December, which is gravely concerning given that it accounts for around 75 per cent of the UK’s output.
Analysts are forecasting a slight contraction in the fourth-quarter of 2012 – the fourth quarter in five that the UK economy will have shrunk. Along with the recent heavy snowfall, there are increasing risks that the UK will fall into a triple-dip recession.
It could also now be a matter of weeks before the UK is stripped of its triple-A rating on the back of mediocre growth and failure to make fiscal progress. This would be the final nail in the coffin, extinguishing any idea that the UK is a safe haven. And if one major rating agency downgrades the UK, the rest will soon follow.
Sterling will react violently to the news, and the bond markets will spike higher. Many have warned of the UK’s weak fundamentals. The consequences may soon be upon us.